I’ve written so much about the Dodd-Frank Bill that I’m kind of exhausted with it. But Mark Thoma and Noah Millman, using the same list, write out their thoughts on the financial reform bill. I’m a fan of Noah writing about finance and both are worth reading. I’m going to add a few high-level thoughts to what they wrote using their framework.

Consumer Protection Agency. A lot of the headache we are suffering through now could have been avoided if Alan Greenspan enforced consumer protection laws in the subprime market, notably the 1994 The Home Ownership and Equity Protection Act. Ned Gramlich urged Greenspan to have the Fed start regulating subprime, which he could do when HSBC and others started buying out subprime lenders. So did the GAO and a HUD-Treasury task force. Greenspan wouldn’t. And here we are. Having consumer protection as a third or fourth priority across many agencies doesn’t cut it: We need an agency with this as its first priority. The benefit in fraud pays out more than the penalties with the way the current system works. As much as some like this system because it punishes people or cross-subsidizes those who have extra money, overall it’s a system that could use some simple guidelines in contract writing and law enforcement.

Also: At heart, I’m a data nerd, so the ability of the CFPB to collect, analyze, research and make data public is one of the most interesting pieces of it. We might get better data on consumer debt than the of-interest-to-only-macroeconomists aggregate data that is currently public. And that data and research can give us a better picture of who the financial sector work well for and who it doesn’t work for at all.

Derivatives Traded on Exchanges. Noah: “What was important was the lack of a central clearinghouse because that meant that there was no generally agreed upon mechanism for establishing valuations and posting collateral. AIG was insuring huge amounts of risk and posting nothing; then they got downgraded, had to start posting collateral, therefore had to come up with some idea of what their stuff was actually worth, and rapidly entered a death spiral. If derivatives all trade through a central clearing corporation, then everybody has to post collateral and leverage is limited by the clearing corporation. That’s the way the listed options market works and the way the listed futures market works, and it’s how the credit derivatives market should work as well. And, as a side effect, you probably get better price discovery. So this is a good reform.”

I agree. I worry about the “end-user” exemption getting defined too broadly, and industrials being encouraged to run mini-hedge funds out of their offices and other juking through this mechanism. This is something to be monitored for years to come – how many derivatives are being cleared, on what terms are swap execution facilities being defined, and how much price transparency are market agents getting?

Resolution Authority. Noah: “This is a vital reform but people should understand that it has a very limited effect. Basically, this gives regulators the authority to do with a future AIG what they could do with a normal bank. That eliminates a big element of uncertainty going into negotiations between regulators and the company in question during a crisis, and therefore should mitigate the market panic during a crisis. It doesn’t address any questions of fairness associated with bailouts, and it doesn’t really do anything to prevent a crisis from happening, but it should prevent another Lehman Brothers-type total market meltdown when the next crisis occurs. If you look at the difference between how Lehman and Washington Mutual were handled respectively, you can see the vital importance of this reform.”

I mostly agree. I am still up in the if we would have actually used this resolution authority on Lehman and/or Bear in 2008. I like to think we would have, but there’s some uncertainty there.

Too Big To Fail. I’ll take this as the SAFE Banking Amendment.

I’ll discuss this more in Leverage Ratios below, but I’m skeptical on Basel III getting a solid handle of liquidity-reserving requirements, and the SAFE Banking Amendment putting a hard cap on non-deposit liabilities would have saved us a lot of headache in praying that the international banking community doesn’t destroy a moderate “Bear Stern Rule” on liquidity through the process. Beyond that, the political pressures of the biggest banks, the lack of demonstrable value, the fact that the biggest players didn’t do any better worse in the stress test in terms of expected losses for all their magic “diversification”:

And the number of other reasons, including whether or not resolution authority is credible on an institution with 7% of GDP in non-deposit liabilities, made me think this would have been a smart move.

Volcker Rule Too Weak. The 3% loophole is a sad thing to see. The banks were gunning for 10%, so I do have to give credit for what they were able to keep Brown et al to in terms of the size of the loophole. But for a clear boundary to keep our commercial banks from becoming de facto hedge funds and having the huge asymmetry in payouts that come with picking up nickels in front of a steamroller it is a shame.

Fed Audits. In general I am in favor of public scrutiny of emergency powers in a crisis, and the trillions of dollars that the Federal Reserve decided to lend out in the middle of a crisis deserves a public record. There needs to be a symmetry to emergency powers: yes you can take them if necessary to stabilize the system, but you have to allow the public to actually see what was done.

This bill doesn’t fix “the shadow banking system” entirely. The crisis has underscored the fragility of shadow banks’ funding model, which relies on confidence-sensitive wholesale markets to support credit-intensive assets. We get regulators directed for banks to hold extra capital for liquidity, with the rules being kicked to Basel III. Looking at two liquidity parts of the proposal: “The liquidity proposals come in two parts: one, known as the Bear Stearns rule, requires banks to have enough liquid assets on hand to survive a 30-day crisis, while the other, nicknamed the Northern Rock rule, requires banks to have stable long-term funding, favouring deposits and heavily disfavouring wholesale sources.” These two proposals are being lobbied against hard, especially the second part. I’d like these rules better if we had a hard rule on non-deposits as a percent of GDP, aka the SAFE Banking Act.

Monitoring Systemic Risk. I think it’s less of an issuing of monitoring bubbles versus knowing how to react to them. There’s clear evidence that Greenspan knew of the housing bubble early on, but decided to not take public action, and deal with the cleanup afterwards. Is that how it is going to go again?

Executive Pay. To the topic of pay more generally, if you have traders and others making “f*** you money” (or “walkaway money”) every year, it’s going to be tough for them to think in terms of the long-term health of the firm.

Credit Ratings Agencies. The people I know who teach CFA classes are frightened at how institutionalized the Ratings Agencies are into the practice of capital reserving. Like the materials can’t imagine a world outside of a ratings mindset. That’s worrisome, though I am no longer at the front lines on this. There’s always been a conflict of interest, but in the case of the AAA securitization it’s impossible to imagine any demand being there if they were AA rated. This bill opens up a lot of the ratings agency’s model; I’m curious as to how banks handle credit risk 5 years from now.

The very fact that rating agencies are institutionalized suggests that improving quality, not just reducing reliance, is a worthy strategy. The Franken Amendment was a serious effort at this, although people can debate the importance of the issuer-pays conflict. Congress should have considered adopting some sort of ex-post relief mechanism that is tied to actual rating quality, rather than nebulous concepts such as “fraud” or “gross negligence.” The SEC’s new authority to de-certify a rating agency that consistently produces poor-quality ratings is a step in the right direction.

On the reducing-reliance side, Dodd-Frank does apparently require all federal agencies to eliminate rating-dependent regulation within one year (Sec. 939A), although the language is not 100% clear. Of course, this won’t directly affect state-level rating-dependent regualation, which is widespread and highly significant because the state-regulated insurance industry is such a large part of the bond market.

The legislation is only a small part of the story here. How (or whether) it will be enforced will determine the usefulness of something that took 6 months to pass. I mean, we have a lot of nice-in-theory workplace safety and environmental laws on the books that regulatory agencies either can’t or don’t enforce.

This financial reform bill is a total loss, it will be gamed into oblivion very shortly.
Just curious why you’re being so kind to it. Soft spot for the Dems, President Obama or something else? Kind of reminds me of Brad DeLong, everything that guy does says, “hire me! appoint me! pretty please!” to the Democratic Party. He also is very soft on Clinton and the Democrats role in deregulating finance. Just like….you, come to think of it!

“I mean, we have a lot of nice-in-theory workplace safety and environmental laws on the books that regulatory agencies either can’t or don’t enforce.”

Thank you for that. That’s a great quote, and captures it all pretty perfectly.

Deja-Vu:

Heh. That’s funny; I don’t expect a random reader to follow this blog regularly but I usually get accused of being too unreasonable in attacking Treasury. And much of this post is about how breaking up the banks via the SAFE Banking Amendment would make the credibility of this reform significantly better just as a matter of implementation even before political influence problems. But whatever.

jphkinghall:

I’m not sure if you’ll see this comment, but if you do I’d be curious as to your opinion as for tying the compensation of the ratings agencies to the life of a the securitization. IE: a problem is that they are paid up front with only a minor watching fee after the securitization has come to life; why not force that payment to be consistent to the life of the instrument and tied to how accurate the rating is? I’ve heard that suggested by friends whose knowledge I respect. Be curious to your opinion.

I re-read the part about SAFE Banking and can’t figure out if you think it’s good or bad. I can’t even tell if you think TBTF is a real problem or not. But then, I’m not a regular reader of this blog. Anyway, Paul Krugman doesn’t think TBTF is a real problem, I happen to think he’s right.
Your “even-handed” approach to this is puzzling. In mine and many other’s opinions the financial reform effort has failed entirely. It is being and has been gamed into complete irrelevance as we speak(or spoke). That’s the important issue, not the “subtleties” of what % of derivatives will be allowed to trade over-the-counter. This is true because once an exception is made in a market like that, then the rule becomes pointless, it’s just another regulation that the financial industry will exploit or get around to do what they want. Why don’t you see this?
The fact that you don’t see or agree that this so-called financial reform bill will change nothing led me to say that you were being too kind to the Democratic Party, which led to my (perhaps unwarranted)speculation about hopes you may have for appointment in the administration.
But then we’re all ambitious, aren’t we?

“Monitoring Systemic Risk. I think it’s less of an issuing of monitoring bubbles versus knowing how to react to them. There’s clear evidence that Greenspan knew of the housing bubble early on, but decided to not take public action, and deal with the cleanup afterwards. Is that how it is going to go again?”

This is exactly wrong. The real question is why did the collapse of the housing bubble nearly take down the entire world economy? That is the issue.
Also, the fact that you didn’t immediately dismiss as an absurdity the idea of measuring or monitoring risk is not a good sign. I would recommend Nassim Taleb’s books. He explains why VAR and other techniques for “measuring” risk are completely intellectually fraudulent.
But wait there’s more! I’ve figured out why you’re being so “even-handed” on the completely pointless financial reform bill. The problem is is that you’re a YAT! No, I don’t mean you’re from Metairie, La., I mean, RB, that you are Yet Another Technocrat.
And if there’s one thing Technocrats love to do, it’s to tinker and talk over various subtleties and fine points in regards to policy( mostly of their own making).
The world is heading towards the abyss(2011), an economic and social catastrophe not unlike what happened in the 1930s. The stakes are too high for even-handed technocrats who can’t even bring themselves to say financial reform has failed.
The outlook is very, very grim indeed.

Mike: What about the shadow banking system? My fear is that it will take another
crisis to, again, get a safe and sound banking system. I doubt that this can
be strenghtened given the political power of the financial industry even after
this crash. However, the next crash, as Martin Wolf, has said will be terrifying.
Who will lend us the trillions to get out of the next one?